- By Daniel W. Drezner
Daniel W. Drezner is professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University and a senior editor at The National Interest. Prior to Fletcher, he taught at the University of Chicago and the University of Colorado at Boulder. Drezner has received fellowships from the German Marshall Fund of the United States, the Council on Foreign Relations, and Harvard University. He has previously held positions with Civic Education Project, the RAND Corporation, and the Treasury Department.
An out-of-control shadow banking system that’s been barely reformed. A housing sector that’s been booming but seems primed for a bust. And despite a recent election that seemed to make it clear who was in charge, gridlock and short-term thinking appear to be hobbling the country’s political elite.
I’m talking, of course, about … China. Well, not me so much as Fitch Ratings, which has turned just a bit bearish on Chinese debt. Why did Fitch downgrade their debt?
China’s growth since the re-launch of market-based economic reform in 1992 has been globally as well as domestically transformative. However, the investment-led growth model faces tightening constraints as the share of investment in GDP approaches the level of domestic savings. The process of rebalancing the economy towards consumption could lead to the economy’s performance becoming more volatile.
Some underlying structural weaknesses weigh on China’s ratings. Average income at USD 5,988 in 2012 and the overall level of development remain well below ‘A’ medians despite China’s phenomenal growth. Standards of governance lag ‘A’ range norms according to the World Bank’s assessment framework….
Risks over China’s financial stability have grown. Credit has grown significantly faster than GDP since 2009. China experienced the second-fastest expansion of credit in real terms, behind only Qatar, between end-2009 and end-June 2012. The stock of bank credit to the private sector was worth 135.7% of GDP at end-2012, the third-highest of any Fitch-rated emerging market.
Fitch believes total credit in the economy including various forms of "shadow banking" activity may have reached 198% of GDP at end-2012, up from 125% at end-2008. Only 55% of new social financing took the form of bank lending in the 12 months to February 2013, down from 76% in 2009. The proliferation of other forms of credit beyond bank lending is a source of growing risk from a financial stability perspective….
The ratings assume there is no significant deterioration of geopolitical risk, for example a conflict between China and Japan or an outbreak of war on the Korean peninsula.
China has faced concerns over debt levels since 2009 when state-owned banks unleashed a surge of loans to power the economy through the global financial crisis. The credit wave succeeded in keeping Chinese growth on track, but it led to bubbly housing prices and also saddled local governments with mountains of loans that they are still struggling to repay.
Beijing has spent the past three years trying to manage these problems. It has waged a long campaign to rein in the real estate sector, raising mortgage downpayments and barring people from buying second homes in the hottest markets. Partly as a result, China recorded its lowest annual growth rate for a decade last year.
Reuters tells a similar tale on China’s shadow banking system.
China’s banks are feeding unwanted assets into the country’s "shadow banking system" on an unprecedented scale, reinforcing suspicions that bank balance sheets reflect only a fraction of the actual credit risk lurking in the financial system….
But the key question is no longer how much risk banks are carrying. Rather, it’s how many risky loans have been shifted to the lightly regulated shadow banking institutions – mainly trust companies, brokerages and insurance companies.
The risk to the overall financial system is not clear, because of insufficient data about the quality of credit in the shadow banking sector.
To be fair to Chinese authorities, they’re quite aware of what they’re going through. Indeed, the entire China 2030 exercise, as well as last month’s China Development Forum, is predicated on the notion that China’s growth model needs to change. But as Martin Wolf notes in his column, as China enters "middle income trap" territory, there are significant problems with such reforms:
First, if expected growth falls from over 10 to, say, 6 per cent, the needed rate of investment in productive capital will collapse: under a constant incremental capital output ratio the fall would be from 50 per cent to, say, 30 per cent of GDP. If swift, such a decline would cause a depression, all on its own.
Second, a big jump in credit has gone together with reliance on real estate and other investments with falling marginal returns. Partly for this reason, the decline in growth is likely to mean a rise in bad debts, not least on the investments made on the assumption that past growth would continue. The fragility of the financial system could increase very sharply, not least in the rapidly expanding “shadow banking” sector.
Third, since there is little reason to expect a decline in the household savings rate, sustaining the envisaged rise in consumption, relative to investment, demands a matching shift in incomes towards households and away from corporations, including state enterprises. This can happen: the growing labour shortage and a move towards higher interest rates might deliver it smoothly. But, even so, there is also a clear risk that the resulting decline in profits would accelerate a collapse in investment.
I’d add only two things at this point. First, as far as I’m concerned, one of the great mysteries in comparative political economy is why it’s so bloody difficult for countries like Germany, Japan, and China to change their growth models. High-saving export-oriented economies don’t change their ways all that much. To be fair, neither do low-saving, high import countries like the United States. This could be a "varieties of capitalism" story, but that seems … inadequate as an explanation.
Second, it’s worth remembering that the conventional wisdom about China’s government was that annual growth below eight percent a year would spell trouble for the government. The implicit contract over the past three decades was that the Chinese Communist Party would supply the growth in return for political quiescence. The end of high growth would imply that this social contract is in trouble.
Except that China’s growth has been below that rate for the last two years and running. During that time, Beijing has weathered one major political scandal, a raft of minor political scandals, and a leadership transition without a hint of regime collapse. So while China’s economy does seem to merit greater attention, I’m not sure that China’s political economy will trigger the kinds of instability that have been predicted for so long.
What do you think?